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218 Principles of Real Estate Practice
16 Appraising and Estimating
Market Value
Real Estate Value
Appraising Market Value
The Sales Comparison Approach
The Cost Approach
The Income Capitalization Approach
Regulation of Appraisal Practice
REAL ESTATE VALUE
Foundations of real estate value Types of value
The valuation of real property is one of the most fundamental activities in the real estate business. Its role is particularly critical in the transfer of real property, since the value of a parcel establishes the general price range for the principal parties to negotiate.
Real estate value in general is the present monetary worth of benefits arising from the ownership of real estate. The primary benefits that contribute to real estate value are:
income appreciation use tax benefits
Ownership of real estate produces income when there are leases on the land, the improvements, or on air, surface, or subsurface rights. Such income is part of real estate value because an investor will pay money to buy the income stream generated by ownership of the property.
Appreciation is an increase in the market value of a parcel of land over time, usually resulting from a general rise in sale prices of real estate throughout a market area. Such an increase, whether actual or projected, is another investment benefit that contributes to real estate value.
The way a property is used -- whether residential, commercial, agricultural, recreational, etc. -- in large part determines the property's value. Each kind of use has its own benefits.
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Depending on current tax law, tax benefits from ownership of a property may take the form of preferred treatment of capital gain, tax losses, depreciation, and deferrals of tax liability. These tax benefits contribute to the income and potential sale price of a property. Foundations of real estate value A number of economic forces interact in the marketplace to contribute to real estate value. Among the most recognized of these principles are those listed below.
Exhibit 16.1 Economic Principles Underlying Real Estate Value
supply and demand utility transferability anticipation substitution contribution
change highest and best use conformity progression and regression assemblage subdivision
Supply and demand. The availability of certain properties interacts with the strength of the demand for those properties to establish prices. When demand for properties exceeds supply, a condition of scarcity exists, and real estate values rise. When supply exceeds demand, a condition of surplus exists, and real estate values decline. When supply and demand are generally equivalent, the market is considered to be in balance, and real estate values stabilize.
Utility. The fact that a property has a use in a certain marketplace contributes to the demand for it. Use is not the same as function. For instance, a swampy area may have an ecological function as a wetland, but it may have no economic utility if it cannot be put to some use that people in the marketplace are willing to pay for.
Transferability. How readily or easily title or rights to real estate can be transferred affects the property's value. Property that is encumbered has a value impairment since buyers do not want unmarketable title. Similarly, property that cannot be transferred due to disputes among owners may cause the value to decline, because the investment is wholly illiquid until the disputes are resolved.
Anticipation. The benefits a buyer expects to derive from a property over a holding period influence what the buyer is willing to pay for it. For example, if an investor anticipates an annual rental income from a leased property to be one million dollars, this expected sum has a direct bearing on what the investor will pay for the property.
Substitution. According to the principle of substitution, a buyer will pay no more for a property than the buyer would have to pay for an equally desirable and available substitute property. For example, if three houses for sale are essentially similar in size, quality and location, a potential buyer is unlikely to choose the one that is priced significantly higher than the other two.
Contribution. The principal of contribution focuses on the degree to which a particular improvement affects market value of the overall property. In essence, the contribution of the improvement is equal to the change in market value that the addition of the improvement causes. For example, adding a bathroom to a house may contribute an additional $15,000 to the appraised value. Thus the contribution of the bathroom is $15,000. Note that an improvement's contribution
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Exhibit 16.2 Types of Real Estate Value market reproduction replacement salvage plottage assessed condemned
reversionary appraised rental leasehold insured book mortgage
Market value. Market value is an estimate of the price at which a property will sell at a particular time. This type of value is the one generally sought in appraisals and used in brokers' estimates of value.
Reproduction value. Reproduction value is the value based on the cost of constructing a precise duplicate of the subject property's improvements, assuming current construction costs.
Replacement value. Replacement value is the value based on the cost of constructing a functional equivalent of the subject property's improvements, assuming current construction costs.
Salvage value. Salvage value refers to the nominal value of a property that has reached the end of its economic life. Salvage value is also an estimate of the price at which a structure will sell if it is dismantled and moved.
Plottage value. Plottage value is an estimate of the value that the process of assemblage adds to the combined values of the assembled properties.
Assessed value. Assessed value is the value of a property as estimated by a taxing authority as the basis for ad valorem taxation.
Condemned value. Condemned value is the value set by a county or municipal authority for a property which may be taken by eminent domain.
Depreciated value. Depreciated value is a value established by subtracting accumulated depreciation from the purchase price of a property.
Reversionary value. Reversionary value is the estimated selling price of a property at some time in the future. This value is used most commonly in a proforma investment analysis where, at the end of a holding period, the property is sold and the investor's capital reverts to the investor.
Appraised value. Appraised value is an appraiser's opinion of a property's value.
Rental value. Rental value is an estimate of the rental rate a property can command for a specific period of time.
Leasehold value. Leasehold value is an estimate of the market value of a lessee's interest in a property.
Insured value. Insured value is the face amount a casualty or hazard insurance policy will pay in case a property is rendered unusable.
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Book value. Book value is the value of the property as carried on the accounts of the owner. The value is generally equal to the acquisition price plus capital improvements minus accumulated depreciation.
Mortgage value. Mortgage value is the value of the property as collateral for a loan.
APPRAISING MARKET VALUE
Market value The appraisal and its uses Steps in the appraisal process
Market value Market value is an opinion of the price that a willing seller and willing buyer would probably agree on for a property at a given time if:
the transaction is a cash transaction the property is exposed on the open market for a reasonable period buyer and seller have full information about market conditions and about potential uses there is no abnormal pressure on either party to complete the transaction buyer and seller are not related (it is an "arm's length" transaction) title is marketable and conveyable by the seller the price is a "normal consideration," that is, it does not include hidden influences such as special financing deals, concessions, terms, services, fees, credits, costs, or other types of consideration.
Another way of describing market value is that it is the highest price that a buyer would pay and the lowest price that the seller would accept for the property.
The market price, as opposed to market value, is what a property actually sells for. Market price should theoretically be the same as market value if all the conditions essential for market value were present. Market price, however, may not reflect the analysis of comparables and of investment value that an estimate of market value includes. The appraisal and its uses While most appraisals seek to estimate market value, any of the types of value described earlier may be the objective of an appraisal. An appraisal is distinguished from other estimates of value in that it is an opinion of value supported by data and performed by a professional, disinterested third party. Appraisers acting in a professional capacity are also regulated by state laws and bound to standards set by the appraisal industry.
Broker's opinion of value. A broker's opinion of value may resemble an appraisal, but it differs from an appraisal in that it is not necessarily performed by a disinterested third party or licensed professional and it generally uses only a limited form of one of the three appraisal approaches. In addition, the opinion is not subject to regulation, nor does it follow any particular professional standards.
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Highest and best use. The third step is to analyze market conditions to identify the most profitable use for the subject property. This use may or may not be the existing use.
Land value. The fourth step is to estimate the land value of the subject. An appraiser does this by comparing the subject site, but not its buildings, with similar sites in the area, and making adjustments for significant differences.
Three approaches. The fifth step is to apply the three basic approaches to value to the subject: the sales comparison approach, the cost approach, and the income capitalization approach. Using multiple methods serves to guard against errors and to set a range of values for the final estimate.
Reconciliation. The sixth step is to reconcile the value estimates produced by the three approaches to value into a final value estimate. To do this, an appraiser must
weigh the appropriateness of a particular approach to the type of property being appraised take into account the quality and quantity of data obtained in each method
Report. The final step is to present the estimate of value in the format requested by the client.
THE SALES COMPARISON APPROACH
Steps in the approach Identifying comparables Adjusting comparables Weighting comparables Broker's comparative market analysis
The sales comparison approach, also known as the market data approach , is used for almost all properties. It also serves as the basis for a broker's opinion of value. It is based on the principle of substitution-- that a buyer will pay no more for the subject property than would be sufficient to purchase a comparable property-- and contribution-- that specific characteristics add value to a property.
The sales comparison approach is widely used because it takes into account the subject property's specific amenities in relation to competing properties. In addition, because of the currency of its data, the approach incorporates present market realities.
The sales comparison approach is limited in that every property is unique. As a result, it is difficult to find good comparables, especially for special-purpose properties. In addition, the market must be active; otherwise, sale prices lack currency and reliability.
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Steps in the approach The sales comparison approach consists of comparing sale prices of recently sold properties that are comparable with the subject, and making dollar adjustments to the price of each comparable to account for competitive differences with the subject. After identifying the adjusted value of each comparable, the appraiser weights the reliability of each comparable and the factors underlying how the adjustments were made. The weighting yields a final value range based on the most reliable factors in the analysis.
Exhibit 16.4 Steps in the Sales Comparison Approach
- Identify comparable sales.
- Compare comparables to the subject and make adjustments to comparables.
- Weight values indicated by adjusted comparables for the final value estimate of the subject.
Identifying comparables To qualify as a comparable, a property must:
resemble the subject in size, shape, design, utility and location have sold recently, generally within six months of the appraisal have sold in an arm's-length transaction
An appraiser considers three to six comparables, and usually includes at least three in the appraisal report.
Appraisers have specific guidelines within the foregoing criteria for selecting comparables, many of which are set by secondary market organizations such as FNMA. For example, to qualify as a comparable for a mortgage loan appraisal, a property might have to be located within one mile of the subject. Or perhaps the size of the comparable must be within a certain percentage of improved area in relation to the subject.
The time-of-sale criterion is important because transactions that occurred too far in the past will not reflect appreciation or recent changes in market conditions.
An arm's length sale involves objective, disinterested parties who are presumed to have negotiated a market price for the property. If the sale of a house occurred between a father and a daughter, for example, one might assume that the transaction did not reflect market value.
Principal sources of data for generating the sales comparison are tax records, title records, and the local multiple listing service.
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Weighting comparables Adding and subtracting the appropriate adjustments to the sale price of each comparable results in an adjusted price for the comparables that indicates the value of the subject. The last step in the approach is to perform a weighted analysis of the indicated values of each comparable. The appraiser, in other words, must identify which comparable values are more indicative of the subject and which are less indicative.
An appraiser primarily relies on experience and judgment to weight comparables. There is no formula for selecting a value from within the range of all comparables analyzed. However, there are three quantitative guidelines: the total number of adjustments; the amount of a single adjustment; and the net value change of all adjustments.
As a rule, the fewer the total number of adjustments, the smaller the adjustment amounts, and the less the total adjustment amount, the more reliable the comparable.
Number of adjustments. In terms of total adjustments, the comparable with the fewest adjustments tends to be most similar to the subject, hence the best indicator of value. If a comparable requires excessive adjustments, it is increasingly less reliable as an indicator of value. The underlying rationale is that there is a margin of error involved in making any adjustment. Whenever a number of adjustments must be made, the margin of error compounds. By the time six or seven adjustments are made, the margin becomes significant, and the reliability of the final value estimate is greatly reduced.
Single adjustment amounts. The dollar amount of an adjustment represents the variance between the subject and the comparable for a given item. If a large adjustment is called for, the comparable becomes less of an indicator of value. The smaller the adjustment, the better the comparable is as an indicator of value. If an appraisal is performed for mortgage qualification, the appraiser may be restricted from making adjustments in excess of a certain amount, for example, anything in excess of 10-15% of the sale price of the comparable. If such an adjustment would be necessary, the property is no longer considered comparable.
Total net adjustment amount. The third reliability factor in weighting comparables is the total net value change of all adjustments added together. If a comparable's total adjustments alter the indicated value only slightly, the comparable is a good indicator of value. If total adjustments create a large dollar amount between the sale price and the adjusted value, the comparable is a poorer indicator of value. Fannie Mae, for instance, will not accept the use of a comparable where total net adjustments are in excess of 15% of the sale price.
For example, an appraiser is considering a property that sold for $100,000 as a comparable. After all adjustments are made, the indicated value of the comparable is $121,000, a 21% difference in the comparable's sale price. This property, if allowed at all, would be a weak indicator of value.
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Broker's comparative market analysis A broker or salesperson who is attempting to establish a listing price or range of prices for a property uses a scaled-down version of the appraiser's sales comparison approach called a comparative market analysis, or CMA (also called a competitive market analysis). While the CMA serves a useful purpose in setting general price ranges, brokers and agents need to exercise caution in presenting a CMA as an appraisal, which it is not. Two important distinctions between the two are objectivity and comprehensiveness.
First, the broker is not unbiased: he or she is motivated by the desire to obtain a listing, which can lead one to distort the estimated price. Secondly, the broker's CMA is not comprehensive: the broker does not usually consider the full range of data about market conditions and comparable sales that the appraiser must consider and document. Therefore, the broker's opinion will be less reliable than the appraiser's.
The following exhibit illustrates the sales comparison approach. An appraiser is estimating market value for a certain house. Four comparables are adjusted to find an indicated value for the subject. The grid which follows the property and market data shows the appraiser's adjustments for the differences between the four comparables and the subject.
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Exhibit 16.5, cont. Sales Comparison Approach Illustration
Adjustments
Subject A B C D
Sale price 1,000,000 1,200,000 1,150,000 1,090,
Financing terms standard standard standard standard
Sale date NOW equal equal equal equal
Location equal equal equal -20,
Age equal -12,000 +10,000 equal
Lot size +10,000 +10,000 -10,000 equal
Site/view equal -10,000 equal equal
Design/appeal +10,000 -12,000 equal +5,
Construction quality good equal -30,000 equal +10,
Condition good equal -50,000 equal +20,
No. of rooms 8
No. of bedrooms 3 +5,000 -5,000 equal +5,
No. of baths 2 +10,000 -15,000 equal +5,
Gross living area 5,000 +10,000 -20,000 equal +10,
Other space
Garage 2 car/attd. equal equal equal equal
Other improvements
Landscaping good equal equal equal equal
Net adjustments +45,000 -144,000 0 +35,
Indicated value 1,120,000 1,045,000 1,056,000 1,150,000 1,125,
For comparable A, the appraiser has made additions to the lot value, design, number of bedrooms and baths, and for gross living area. This accounts for the comparable's deficiencies in these areas relative to the subject. A total of five adjustments amount to $45,000, or 4.5% of the purchase price.
For comparable B, the appraiser has deducted values for age, site, design, construction quality, condition, bedrooms, baths, and living area. This accounts for the comparable's superior qualities relative to the subject. The only addition is
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the lot size, since the subject's is larger. A total of nine adjustments amount to $144,000, or 12% of the sale price.
For comparable C, the appraiser has added value for the age and deducted value for the lot size. The two adjustments offset one another for a net adjustment of zero.
For comparable D, one deduction has been made for the comparable's superior location. This is offset by six additions reflecting the various areas where the comparable is inferior to the subject. A total of seven adjustments amount to $35,000, or 3.2% of the sale price.
In view of all adjusted comparables, the appraiser developed a final indication of value of $1,120,000 for the subject. Underlying this conclusion is the fact that Comparable C, since it only has two minor adjustments which offset each other, it is by far the best indicator of value. Comparable D might be the second best indicator, since the net adjustments are very close to the sale price. Comparable A might be the third best indicator, since it has the second fewest number of total adjustments. Comparable B is the least reliable indicator, since there are numerous adjustments, three of which are of a significant amount. In addition, Comparable B is questionable altogether as a comparable, since total adjustments alter the sale price by12%.
THE COST APPROACH
Types of cost appraised Depreciation Steps in the approach
The cost approach is most often used for recently built properties where the actual costs of development and construction are known. It is also used for special-purpose buildings which cannot be valued by the other methods because of lack of comparable sales or income data.
The strengths of the cost approach are that it:
provides an upper limit for the subject's value based on the undepreciated cost of reproducing the improvements is very accurate for a property with new improvements which are the highest and best use of the property.
The limitations of the cost approach are that:
the cost to create improvements is not necessarily the same as market value depreciation is difficult to measure, especially for older buildings
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Steps in the approach The cost approach consists of estimating the value of the land "as if vacant;" estimating the cost of improvements; estimating and deducting accrued depreciation; and adding the estimated land value to the estimated depreciated cost of the improvements.
Exhibit 16.6 Steps in the Cost Approach
- Estimate land value.
- Estimate reproduction or replacement cost of improvements.
- Estimate accrued depreciation.
- Subtract accrued depreciation from reproduction or replacement cost.
- Add land value to depreciated reproduction or replacement cost.
Estimate land value. To estimate land value, the appraiser uses the sales comparison method: find properties which are comparable to the subject property in terms of land and adjust the sale prices of the comparables to account for competitive differences with the subject property. Common adjustments concern location, physical characteristics, and time of sale. The indicated values of the comparable properties are used to estimate the land value of the subject. The implicit assumption is that the subject land is vacant (unimproved) and available for the highest and best use.
Estimate reproduction or replacement cost of improvements. There are several methods for estimating the reproduction or replacement cost of improvements. These are as follows.
Unit comparison method (square-foot method) The appraiser examines one or more new structures that are similar to the subject's improvements, determines a cost per unit for the benchmark structures, and multiplies this cost per unit times the number of units in the subject. The unit of measurement is most commonly denominated in square feet.
Unit-in-place method The appraiser uses materials cost manuals and estimates of labor costs, overhead, and builder's profit to estimate the cost of constructing separate components of the subject. The overall cost estimate is the sum of the estimated costs of individual components.
Quantity survey method The appraiser considers in detail all materials, labor, supplies, overhead and profit to get an accurate estimate of the actual cost to build the improvement. More thorough than the unit-in-place
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method, this method is used less by appraisers than it is by engineers and architects.
Cost indexing method
The original cost of constructing the improvement is updated by applying a percentage increase factor to account for increases in nominal costs over time.
Estimate accrued depreciation. Accrued depreciation is often estimated by the straight-line method, also called the economic age-life method. This method assumes that depreciation occurs at a steady rate over the economic life of the structure. Therefore, a property suffers the same incremental loss of value each year.
The economic life is the period during which the structure is expected to remain useful in its original use. The cost of the structure is divided by the number of years of economic life to determine an annual amount for depreciation. The straight-line method is primarily relevant to depreciation from physical deterioration.
Subtract accrued depreciation from reproduction or replacement cost. The sum of accrued depreciation from all sources is subtracted from the estimated cost of reproducing or replacing the structure. This produces an estimate of the current value of the improvements.
Add land value to depreciated reproduction or replacement cost. To complete the cost approach, the estimated value of the land "as if vacant" is added to the estimated value of the depreciated reproduction or replacement cost of the improvements. This yields the final value estimate for the property by the cost approach.
236 Principles of Real Estate Practice
The strength of the income approach is that it is used by investors themselves to determine how much they should pay for a property. Thus, in the right circumstances, it provides a good basis for estimating market value.
The income capitalization approach is limited in two ways. First, it is difficult to determine an appropriate capitalization rate. This is often a matter of judgment and experience on the part of the appraiser. Secondly, the income approach relies on market information about income and expenses, and it can be difficult to find such information.
Steps in the approach The income capitalization method consists of estimating annual net operating income from the subject property, then applying a capitalization rate to the income. This produces a principal amount that the investor would pay for the property.
Exhibit 16.8 Steps in the Income Capitalization Approach
- Estimate potential gross income.
- Estimate effective gross income.
- Estimate net operating income.
- Select a capitalization rate.
- Apply the capitalization rate.
Estimate potential gross income. Potential gross income is the scheduled rent of the subject plus income from miscellaneous sources such as vending machines and telephones. Scheduled rent is the total rent a property will produce if fully leased at the established rental rates.
Scheduled rent
Potential gross income
An appraiser may estimate potential gross rental income using current market rental rates (market rent), the rent specified by leases in effect on the property (contract rent), or a combination of both. Market rent is determined by market studies in a process similar to the sales comparison method. Contract rent is used primarily if the existing leases are not due to expire in the short term and the tenants are unlikely to fail or leave the lease.
Estimate effective gross income. Effective gross income is potential gross income minus an allowance for vacancy and credit losses.
Potential gross income
Effective gross income
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Vacancy loss refers to an amount of potential income lost because of unrented space. Credit loss refers to an amount lost because of tenants' failure to pay rent for any reason. Both are estimated on the basis of the subject property's history, comparable properties in the market, and assuming typical management quality. The allowance for vacancy and credit loss is usually estimated as a percentage of potential gross income.
Estimate net operating income. Net operating income is effective gross income minus total operating expenses.
Effective gross income
Net operating income
Operating expenses include fixed expenses and variable expenses. Fixed expenses are those that are incurred whether the property is occupied or vacant, for example, real estate taxes and hazard insurance. Variable expenses are those that relate to actual operation of the building, for example, utilities, janitorial service, management, and repairs.
Operating expenses typically include an annual reserve fund for replacement of equipment and other items that wear out periodically, such as carpets and heating systems. Operating expenses do not include debt service, expenditures for capital improvements, or expenses not related to operation of the property.
Select a capitalization rate. The capitalization rate is an estimate of the rate of return an investor will demand on the investment of capital in a property such as the subject. The judgment and market knowledge of the appraiser play an essential role in the selection of an appropriate rate for the subject property. In most cases, the appraiser will research capitalization rates used on similar properties in the market.
Apply the capitalization rate. An appraiser now obtains an indication of value from the income capitalization method by dividing the estimated net operating income for the subject by the selected capitalization rate
Using traditional symbols for income (I), rate (R) and value (V), the formula for value is
I ----- = V R
